You might be asking yourself this question.
Right now, many people are.
Lots of people are scared, too. Some are even pulling money out of their portfolios to “rescue” what they have left.
So I thought I’d address the question,
Should I invest in the stock market?
I don’t know. I’d be a bad financial advisor (I’m not an advisor) if I gave any other answer with the information I have about your financial situation (zero).
While I can’t help you answer that question here, we can look at data that can help you answer the question for yourself.
You take what you learn to make the decision your own.
So this is going to be a data post. I’ll be showing you some data. I’ll comment on the data, say things like “wow, that’s interesting” and talk about what I see. It’s going to be very interesting.
We’ll use historical data from the S&P 500 for this discussion. We have a lot of data for it!
And of course it must be said, past performance is no guarantee of future results. But the only data I have available is from the past.
Here’s a chart of the S&P 500 going back to 1871:
It doesn’t really tell us much, other than it moves – in general – up and to the right. At least after 1952. I can’t see well what’s going on before that because the numbers are small relative to what they are today.
Changing to a logarithmic scale helps out a bit:
Moves up and to the right even before 1952 – in general.
So far, we’ve gathered that an investment in the stock market will produce positive returns eventually. Even if you bought into the market at the peak just before the 1928 crash, you’d be in positive territory as long as you continued to hold.
But that’s not how we usually invest; we don’t invest in the market and leave our money in there forever. We die at some point. I’d love to meet someone who’s been in the market since 1928.
Typically, we want to grow our money to take it out at some point so we can use it for its earmarked purpose. Buying a house, funding our retirement, getting married, kid expenses…
There are so many things we need money for, and we have access to so many different vehicles. Savings accounts, CDs, Real Estate, Bonds, etc. When would we choose one over the other?
When does the stock market make sense?
You have probably heard that investing in the market is a good choice if you’re investing for the long haul.
True. But how long is long?
Three years can be a loooong time, especially the insta-gratification generations.
Luckily, there’s a thing called the normal distribution can help us answer this question objectively.
I’ll state upfront that the normal distribution may not be the absolute best way to model stock market returns. But we’re looking for something good enough to provide a good enough understanding of and answer to the question.
This guy does a better job at explaining what a normal distribution is than I’ll be able to:
Let’s look at the normal distribution for returns of a one year investment in the S&P 500, I’ll explain what it means, then we’ll look at what the 5, 10, 20, and 30 year charts.
A few notes:
- The charts will show the REAL return, meaning that it’s adjusted for inflation.
- The S&P 500 pays a dividend. You can choose what to do with those dividends. The blue line assumes that when you receive a dividend payment, you immediately use it to buy more shares.
What you’re seeing here is the likelihood of a return being achieved over a one-year period. This is calculated by starting with any year in our dataset (1871-2019) and seeing where you’d be after one year. We repeat this every year possible to create the chart you see above.
For example, according to probability theory, the most likely return that you’ll get if you put your money into the S&P 500 for one year is around 9% (4% without dividends reinvested). Not bad. But you also have about a 40% or so chance of “losing money.” Then again, that leaves a decent odds of having a positive return.
Still a gamble though. If I know I need to use the money within a year, I probably would not put it in the stock market.
The difference between reinvesting and keeping dividends is not overly significant for a one year investment.
Let’s look at the five year chart:
Again, we start at any year, then see where we are five years later.
The chart’s moved to the right, and there is a bigger difference between reinvesting dividends and not.
I’m eyeballing this, but it looks like there’s about a 33% chance of having a negative return with dividends reinvested.
Let’s increase to ten years:
Reminds me of plate tectonics. The dividend mountain is on a plate that moves to higher returns faster.
A ten year holding period is looking quite nice. Historically, the worst performance you’d get after a ten year period holding the S&P 500 is -4%. And the probability of that occurring was less than 1%.
Let’s hold longer.
Historically, holding for 20 years with dividends reinvested guaranteed a positive return, the median/mean/standard/most likely return being 6.81%.
At this point, I’m sure you’re getting a real sense for what to say when your broker asks you what you want to do with your dividends.
20+ years is a good amount of time to be invested in the market. Most people who are using indexed stock market investment to save for retirement can stay in the market for at least this long. Young people at the beginning of their working and investing lives have twice that amount of time.
You might even have 30+ years.
How about that?
As a bonus, and because you’re probably wondering, I want to show you what the long-term difference looks like with and without dividends reinvested. The charts above just don’t do it justice.
Let’s say that in 1871 you invested $1 into an S&P 500 fund. Your broker asked you if you wanted to reinvest the dividends. Here’s the difference between a ‘yes’ and ‘no.’
Reinvesting unleashes the power of compounding.
You’ll find this true not just for stock investments, but for most things in life.
It took me over six months of researching the stock market to understand how it works and what all the rage was about. I then spent four years pouring as much of my income into index funds as I could manage.
A lot of people are afraid of investing in the stock market because it’s risky. They’re afraid of losing 40% of their portfolio in a few months time. They don’t like the idea of having no control over their money. They’d rather have guarantees and protection from downturns. Valid concerns. Certain life situations require such planning. But the alternatives their fear drives them into often leave them with less than what the raw market would have given them.
Again, it all comes down to education and understanding.
For me, the stock market is one of the safest places to park my money.
And that’s where I have it.
For my life situation, I have no concerns with this allocation. I keep a little bit in other things just to have a bit of flexibility (like being able to buy at COVID-19 discount) and for fun. But this is as safe as can be for me. In fact, it would be more risky for me to be in cash or bonds.
I may have to start calling this my emergency fund.
Of course, there are other factors that play into my confidence. I’m optimistic about the future and believe that the best is yet to come.
Japan’s NIKKEI is often pointed to as an example of how wrong an investment in the stock market can go, even with the buy-and-hold-for-a-long-time strategy.
It has certainly had a hard time for the past thirty years. I may or may not have a different opinion about investing in my country’s market if I were living in Japan. I don’t know, but I thought I’d show you the chart because all markets are not created equal.
Don’t get me wrong, I’m not saying there are no better places to put your money. There sure are. And hey, there may come a point where I move on from stocks completely.
You never know what will happen!
But there are things you can can say will happen with a high degree of certainty.